Last In, First Out (LIFO) is an inventory accounting method where the last items added to inventory are considered the first items to be sold or used. This means that the inventory at the end of a period consists of the items that were added first.
LIFO is one of several inventory valuation methods used in accounting to determine the cost of goods sold (COGS) and the value of ending inventory. Under LIFO, it’s assumed that the most recent inventory costs are matched against the latest sales, leaving the oldest inventory costs to be matched against unsold inventory.
The choice of inventory valuation method can have significant tax implications. In periods of rising prices, LIFO results in a higher COGS and lower ending inventory, which can lead to lower taxable income compared to other methods like First In, First Out (FIFO).
Key aspects of LIFO include:
A company that stocks a particular type of battery adds 100 units at $1 each in January and another 100 units at $1.50 each in February. If they sell 150 units by the end of February and use LIFO, the COGS would be calculated based on the 100 units from February and 50 units from January.
A bakery using LIFO might value its inventory based on the cost of ingredients purchased most recently, even if some of the older ingredients are still in stock.
First In, First Out (FIFO), Inventory Valuation, Cost of Goods Sold (COGS)
Why would a company choose LIFO over other inventory valuation methods? One primary reason is tax benefits. In inflationary periods, LIFO can result in lower taxable income, leading to tax savings.
Is LIFO allowed for financial reporting in all countries? No, while LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it’s not allowed under International Financial Reporting Standards (IFRS).
How does LIFO affect a company’s financial ratios? LIFO can lead to a lower inventory turnover ratio and a higher COGS, which can impact profitability ratios.
What are the drawbacks of using LIFO? LIFO can result in outdated inventory costs on the balance sheet and might not reflect the actual flow of inventory for some businesses.
How does LIFO impact a company’s cash flow? By potentially reducing taxable income, LIFO can lead to tax savings and, consequently, higher cash flows.
Is LIFO suitable for all types of businesses? LIFO is most suitable for businesses where inventory items are interchangeable, like commodities or raw materials. It might not be ideal for businesses with perishable goods or products that evolve rapidly.